Picking an investment winner – the passive vs active approach

A perennial issue for investors is whether to opt for a cheaper passive investment or pay a premium for an active investment approach. The former simply "buys the index" - ie, buys shares to reflect their weighting in whichever index or sector they are replicating; the latter attempts to second guess the future direction of the market.

Active funds or passive – what’s the difference?

Active funds try to beat stock market indices; passive funds track the indices.

Arguments, please?

Passive investing is fine, said UK manager Richard Buxton last week, but it’s “better to buy more of the stocks that will rise, and less of the ones that will fall. . . Man has to be better than the machine”.

Passive proponents, such as finance professor and author Burton Malkiel, say a chimp throwing darts at the Wall Street Journal could select a portfolio as good as the "experts".

A chimp? Hardly!

It’s true. Last year, like most years, two-thirds of US large-cap funds trailed the S&P 500. Just 10 per cent beat their benchmark in both 2011 and 2012.

Over the past 10 years, finance website NerdWallet found, 24 per cent of 7,630 actively managed products beat the index. The true figures are probably worse – funds that closed down were not included.

Is this some peculiar US phenomenon?

No. S&P research shows 66 per cent of global funds underperformed over the past three years. Vanguard found 72 per cent of UK funds underperformed over the last five years, 74 per cent over the last 10 years and 67 per cent over 15 years. For Europe, the figures are 74, 73 and 72 (per cent) for the same periods. Globally, the figures are 74, 64 and 76 per cent, while 82, 87 and 93 per cent of emerging market funds underperformed over those periods.

Don’t active managers offer protection in bear markets, as they have the option of going to cash and taking a defensive posture?

“The belief that bear markets favour active management is a myth,” says S&P. The majority of active funds in eight of nine equity styles were outperformed by indices in the 2008 bear market, and the stats are similar for the 2000-02 bear.

Are fund managers just stupid?

No. You can’t expect most to beat the market – they are the market, and can hardly outperform themselves.

Some will beat the market, some won’t. However, high fees (research, salaries, trading costs) means most must underperform. In the US, the average expense ratio for active funds is 1.3 per cent annually, whereas index funds can be bought for just 0.15 per cent. In Europe, the average charge for an equity exchange-traded fund (ETF) is 0.37 per cent, less than a quarter of the 1.6 per cent charge for the average active equity fund.

“The laws of addition, subtraction, multiplication and division” dictate passive management must win, said Nobel laureate William Sharpe. “Nothing else is required”.

How do active managers respond?

Many of the best, as we will see later, agree most investors should invest passively. Hargreaves Lansdown manager David Smith, on the other hand, recently wrote in the Financial Times that index funds "are only an intelligent strategy if you believe active managers keep the market broadly efficient", and that he was "amazed" by people who argue markets are completely efficient. The passive industry is "parasitic".

True or false?

“Whether markets are efficient or inefficient is beside the point,” indexing guru John Bogle replied. “The cost matters hypothesis is all that is needed to explain why indexing works”.

Markets can indeed be irrational, but they are still difficult to beat. That’s why Nobel-winning behavioural economist Daniel Kahneman argues for a passive approach, even though he regards the theory of efficient markets as nonsense.

As for being parasitic, that’s true, although it’s hardly more moral to donate one’s money to highly-paid fund managers.

Surely it’s not hard to find market-beating strategies?

Market anomalies exist, and many such strategies have been documented. However, the investing world is “littered with the bones of those who knew just what to do, but could not bring themselves to do it”, as author William Bernstein noted. There is also career risk in straying from the crowd – that’s why many active funds are really closet indexers.

Can I find the best active managers by picking yesterday’s winners?

No. The top-ranked UK fund managers between 2001 and 2006 were more likely to fall into the bottom quintile than remain at the top over the following five years. Countless international studies confirm picking past winners doesn’t work. Low costs are a more reliable indicator of future performance.

What about the Warren Buffetts of this world?

Some managers, such as Buffett, unquestionably add value. However, Buffett has recommended low-cost index funds on countless occasions. So has ex-Fidelity manager Peter Lynch, one of the most successful investors of his generation. Contrarian legend David Dreman has also warned that only about 10 per cent of managers beat the market in any decade.

Anything else?

Investors in active funds are likely to make things even worse by chasing performance, dipping in and out of funds when the going gets rough. Dalbar Research found the average fund investor earned 4.25 per cent annually between 1993 and 2012 compared to 8.21 per cent for the S&P 500.

Another study, entitled Looking for Someone to Blame, found investors in active funds are more inclined to blame and exit their fund after a poor run, whereas passive investors are more likely to ride out the storm.

Any downsides to passive?

Yes, according to investing blogger Eddy Elfenbein. “I often hear people, professors especially, say that indexing is the only way to invest. Dear Lord, these people can take the sex out of anything”.

People will still try to beat the market, he says. “It’s a frickin’ blast.”